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Chapter 2

The Financial Environment and

the Level of Interest Rates

Before You Go On Questions and Answers

Section 2.1

1. What critical economic role does the financial system play in the economy?

The financial system is in place to gather money from people and businesses and then

channel these funds to those who need it. An efficient financial system is essential for a

healthy economy. The major players in the U.S. financial system are big institutions such

as the New York Stock Exchange, Citigroup, or State Farm Insurance.

2. What are the two basic ways in which funds flow through the financial system from

lender–savers to borrower–spenders?

There are two basic mechanisms by which funds flow through the financial system: 1)

Funds can flow directly through financial markets, and (2) funds can flow indirectly

through financial institutions.

Section 2.2

1. Why is it difficult for individuals to participate in the direct financial markets?

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The financial markets where direct transactions take place are wholesale markets with a

typical minimum transaction size of $1 million. Major buyers and sellers of securities in

direct financial markets include commercial banks, large corporations, the federal

government, hedge funds, and some wealthy individuals.

2. Why might a firm prefer to have a security issue underwritten by an investment banking

firm?

In the most common type of underwriting arrangement, called firm-commitment

underwriting, the investment banker assumes the risk of buying the new securities from

the issuing company and reselling them to investors. The investment banker guarantees to

buy the entire security issue from the company at a fixed price.

Section 2.3

1. What is the difference between primary and secondary markets?

Primary markets are markets where new securities are sold for the first time. Secondary

markets are where the owners of outstanding securities can sell them to other investors.

They provide the means for investors to sell their securities and get cash.

2. How and why do large business firms use money markets?

Large businesses use money markets to adjust their liquidity positions. If a firm has idle

cash sitting around, it can invest it in negotiable CDs, Treasury bills, or other money

market instruments. On the other hand, if a company has a temporary cash shortage, it

can borrow in the money markets by selling commercial paper at lower interest rates than

it could borrow through a commercial bank.

3. What are capital markets, and why are they important to corporations?

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Capital markets refer to the segment of the marketplace where capital goods are financed

with long-term debt or equities. The most important capital market instruments are

common stocks and corporate bonds. Capital markets are important to corporations

because they allow them to obtain necessary financing.

Section 2.4

1. How does information about a firm’s prospects get reflected in its share price?

Investors act upon the expectations of a firm’s prospects through trading of the securities.

The buying and selling then causes the price of the security to reflect their assessment of

its value.

2. What is strong-form market efficiency? semistrong-form market efficiency? weak-form

market efficiency?

Strong-form market efficiency is a market in which all information, private and public, is

reflected in the price of the security. The semistrong-form of market efficiency suggests

that only public information is reflected in a security’s price, while the weak-form market

efficiency holds that both public and private information is reflected in the current price

of a security, but also both public and private information has not been taken into

account.

Section 2.5

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1. What is financial intermediation, and why is it important?

Financial intermediation is the process of converting financial securities with one set of

characteristics into securities with another set of characteristics. For example, commercial

banks use consumer CD deposits to make loans to small businesses.

2. What are some services that commercial banks provide to businesses?

Commercial banks are the largest financial intermediaries in the economy and offer the

widest range of financial services to businesses. Nearly every business has a significant

relationship with a commercial bank – usually a checking or transaction account and

some type of credit or loan arrangement. In addition, banks do a significant amount of

equipment lease financing.

3. What is an IPO, and what role does an investment banker play in the process?

Investment bankers specialize in helping firms to sell their new debt or equity issues in

financial markets. In an initial public offering (IPO), the investment banker prepares the

new issue for sale and then underwrites the deal. Other functions of the investment

banker in an IPO process include preparing the prospectus, registering the documentation

with the SEC, and providing general financial advice to the issuer.

Section 2.6

1. Explain how the real rate of interest is determined.

The real rate of interest depends on interaction between the rate of return that businesses

can expect to earn on investments in capital goods and savers’ time preference for

consumption today versus willingness to save. Therefore, the real rate of interest is

determined when the desired saving level equals the desired level of investment.

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2. How are inflationary expectations accounted for in the nominal rate of interest?

The nominal interest rate is the rate that is actually observed in the financial markets, and

it is equal to the real interest rate plus the expected annualized changes in commodity

prices, or inflation premium. This is commonly referred to as the Fisher effect.

3. Explain why interest rates follow the business cycle.

Interest rates tend to follow the business cycle to rise during economic expansion and

decline during recession. On the one hand, during an expansion, there is upward pressure

on interest rates as businesses begin to grow and borrow more money. On the other hand,

during a recession, the demand for goods and services is lower, businesses borrow less,

and as a result the economy slows down and the interest rates decline. Typically, the Fed

also loosens credit to stimulate the economy, which puts further downward pressure on

the interest rates.

Self Study Problems

2.1 Economic units that need to borrow money are said to be:

a. Lender–savers

b. Borrower–spenders

c. Lender–spenders

d. Borrower–savers

Solution: Such units are said to be (b) Borrower-spenders.

2.2 Explain what the marketability of a security is and how it is determined.

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Solution: Marketability refers to the ease with which a security can be sold and converted

into cash. The level of marketability depends on the cost of trading the security

and the cost of searching for information.. The lower these costs are, the greater

the security’s marketability.

2.3 What are over-the-counter markets (OTC), and how do they differ from organized

exchanges?

Solution: Securities that are not listed on an organized exchange are sold OTC. An OTC

market differs from an organized exchange in that there is no central trading

location. Security transactions are made via phone or computer as opposed to on

the floor of an exchange.

2.4 What effect does an increase in the demand for business goods and services have on the

real interest rate? What other factors can affect the real interest rate?

Solution: An increase in the demand for business goods and services will cause the desired

borrowing schedule in Exhibit 2.4 to shift to the right, thus increasing the real rate

of interest. Other factors that contribute to increases in the real interest rate

include increases in productivity, changes in technology, or changes in the

corporate tax rate. Demographic factors, such as growth or age of the population,

and cultural differences can also affect the real rate of interest.

2.5 How does the business cycle affect the interest and inflation rates?

Solution: Both the nominal interest and inflation rates follow the business cycle; that is,

they rise with economic expansion and fall in time of recession.

Critical Thinking Questions

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2.1 Explain why total financial assets in the economy must equal total financial liabilities.

Every financial asset must be financed with some type of a claim or liability. Since all of

an economy’s financial assets are just a collection of the individual financial assets, then

they should also sum to the collective claims on those assets in the economy.

2.2 Why don’t small businesses make greater use of the direct credit markets since these

markets enable firms to finance themselves at very low cost?

Direct credit markets are geared toward big, established companies since they are

wholesale in nature and the minimum transaction size is far beyond the needs of a small

business. Small businesses are better off borrowing money from financial intermediaries,

such as commercial banks.

2.3 Explain the economic role of brokers and dealers. How does each make a profit?

Brokers and dealers play a similar economic role in that they both bring buyers and

sellers of a commodity together in a market. However, brokers only facilitate a

transaction by helping the two parties make a transaction and brokers are therefore only

compensated for taking on that role. Dealers on the other hand, take risk in that they will

purchase (sell) a commodity from a seller (buyer) without another buyer (seller)

necessarily being available. In other words, a dealer will take the risk of purchasing

(selling) a commodity and will therefore be compensated for taking that risk.

2.4 Why were commercial banks prohibited from engaging in investment banking activities

until 1999?

Banks had been barred from investment banking following the Great Depression because

it was believed that these activities were too risky for banks. At the time, it was believed

that excessive risk taking by banks had resulted in a large number of bank failures, which

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precipitated the Great Depression. Recent research has exonerated the banking system of

this charge.

2.5 What are two basic services that investment banks provide in the economy?

Investment banks specialize in helping companies sell new debt or equity as well as

provide other services such as broker and dealer services.

2.6 How do large corporations adjust their liquidity in the money markets?

Large corporations can take advantage of money markets to adjust for their liquidity by

selling or buying short-term financial instruments such as commercial paper, CDs, or

Treasury bills. Large corporations with cash surplus can invest in short-term securities,

while corporations with cash shortfall can sell securities or borrow funds on a short-term

basis. Money market instruments have a maturity anywhere between one day and one

year and therefore are very liquid and less risky than long-term debt.

2.7 The CFO of a certain company always wears his green suit on a day that the firm is about

to release positive information about his company. You believe that you can profit from

this information by buying the firm’s shares at the beginning of every day that the CFO

shows up wearing this green suit. Describe which form of market efficiency is consistent

with your belief.

You believe that the CFO’s decision to wear a green suit indicates that positive

information will be announced and that the company’s stock price will increase following

that announcement. If you are correct, knowing what the CFO is wearing before any

announcement is valuable private information which should enable you to earn

abnormally high returns. Therefore, your belief is consistent with the semistrong form of

market efficiency – according to which it is possible to earn abnormally high returns by

trading on private information.

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2.8 Shouldn’t the nominal rate of interest (Equation 2.1) be determined by the actual rate of

inflation (∆Pa), which can be easily measured, rather than by the expected rate of

inflation (∆Pe)?

The nominal rate of interest is a forward-looking measure, and therefore it makes sense

that it is using the expected rate of inflation as opposed to the actual rate of inflation. The

expected rate of inflation is the market’s best estimate of what the inflation rate will be in

the future.

2.9 How does Exhibit 2.5 help explain why interest rates were so high during the early 1980s

as compared to the relatively low interest rates in the early 1960s?

The nominal rate of interest is determined by the real rate of interest plus the expected

rate of inflation, and during the 1980s, the U.S. economy experienced a very high rate of

inflation and, thus, high interest rates. Looking at Exhibit 2.5 we can see that the inflation

increased from less than 2 percent in the 1960s to almost 13 percent in the 1980s. This

was a result of the monetary policy instituted by the U.S. government during this period

of time.

2.10 When determining the real interest rate, what happens to businesses that find themselves

with unfunded capital projects whose rate of return exceeds the firms’ cost of capital?

The real rate of interest reflects a complex set of forces that control the desired level of

lending and borrowing in the economy. In this example, businesses are not investing in

projects where the rate of return exceed the cost of capital. This means that there is

lessened a demand for investment funds at the current real interest rate. This will remain

so until either the real interest rate changes or until something changes for the firm such

as introducing a new technology that will increase the rate of return on projects for the

firm.

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Questions and Problems

2.1 Financial System: What is the role of the financial system, and what are the components

of the system?

LO 1

Solution: The role of the financial system is to gather money from businesses and

individuals and to channel funds to those who need them. The financial system consists

of financial markets and financial institutions.

2.2 Financial System: What does a competitive financial system imply about interest rates?

LO 1

Solution: If the financial system is competitive, one will receive the highest possible rate

for money invested with a bank and the lowest possible interest rate when borrowing

money. Also, only firms with good credit ratings and projects with high rates of return

will be financed.

2.3 Financial System: What is the difference between saver–lenders and borrower–spenders,

and who are the major representatives of each?

LO 1

Solution: Saver–lenders are those who have more money than they need right now. The

principal saver–lenders in the economy are households. Borrower–spenders are those

who need the money saver–lenders are offering. The main borrower–spenders in the

economy are businesses, although households are important mortgage borrowers.

2.4 Financial Markets: List the two ways in which a transfer of funds takes place in an

economy. What is the main difference between these two?

LO 2

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Solution: Funds can flow directly through financial markets or indirectly through

intermediation markets where funds flow through financial institutions first.

2.5 Financial Markets: Suppose you own a security that you know can be easily sold in the

secondary market, but the security will sell at a lower price than you paid for it. What

would this mean for the security’s marketability and liquidity?

LO 3

Solution: As the price of the security is lower than that you paid for it, it has a lower

degree of liquidity to you, the owner. That is because the security cannot now be sold

without a loss in value to the owner. Marketability refers to the ease to which a security

can be sold or converted to cash. The information in the problem does mention a

drastically lower price and so we must conclude that the security’s marketability is not

affected.

2.6 Financial Markets: Why are the direct financial markets also called wholesale markets?

LO 2

Solution: The financial markets are also called wholesale markets because the minimum

transaction or security denomination is $1 million or more.

2.7 Financial Markets: Trader, Inc., a $300 million company, as measured by asset value,

and Horst Corp., is a $35 million company. Both are privately held corporations. Explain

which firm is more likely to go public and register with the SEC, and why.

LO 2

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Solution: Trader, Inc., is more likely to go public. Going through an IPO is a very

expensive process, and given Trader’s higher worth, they are more likely to be positioned

to go through with it.

2.8 Primary Markets: What is a primary market? What does IPO stand for?

LO 3

Solution: A primary market is where new securities are sold for the first time. IPO stands

for initial public offering.

2.9 Primary Markets: Identify whether the following transactions are primary market or

secondary market transactions.

a. Jim Hendry bought 300 shares of IBM through his brokerage account.

b. Peggy Jones bought $5,000 of IBM bonds from the firm.

c. Hathaway Insurance Company bought 500,000 shares of Trigen Corp. when the

company issued stock.

LO 3

Solution:

secondary

secondary

primary

2.10 Investment Banking: What does it mean to “underwrite” a new security issue? What

compensation does an investment banker get from underwriting a security issue?

LO 2

Solution: To underwrite a new security issue means that the investment banker buys the

entire issue from the firm at a guaranteed price and then resells the security to individual

investors or other institutions at a higher price. The difference between the banker’s

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purchase price and the total resale price is called the underwriting spread, and it is the

banker’s compensation. In addition to underwriting new securities, investment banks also

provide other services, such as preparing the prospectus, preparing legal documents to be

filed with the SEC, and providing general financial advice to the issuer.

2.11 Investment Banking: Cranjet, Inc. is issuing 10,000 bonds, and its investment banker

has guaranteed a price of $985 per bond. The investment banker sells the entire issue to

investors for $10,150,000.

a. What is the underwriting spread for this issue?

b. What is the percentage underwriting cost?

c. How much did Cranjet raise?

LO 2

Solution:

a. $300,000 ($10,150,000 – $985 x 10,000)

b. 3.05 percent ($30/$985)

c. $9,850,000 ($985 x 10,000)

2.12 Financial Institutions: What are some of the ways in which a financial institution or

intermediary can raise money?

LO 6

Solution: A financial intermediary can raise money through the sale of financial products

that individuals or businesses will purchase, such as checking and savings accounts, life

insurance policies, or pension or retirement funds.

2.13 Financial Institutions: How do financial institutions act as intermediaries to provide

services to small businesses?

LO 5

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Solution: Financial intermediation is the process whereby borrowing occurs indirectly

from a financial institution that has converted financial securities with one set of

characteristics into securities with another set of characteristics for the borrower’s

specific need.

2.14 Financial Institutions: Which financial institution is usually the most important to

businesses?

LO 5

Solution: The primary financial intermediaries are commercial banks, life insurance

companies, casualty insurance companies, pension funds, investment funds, and business

finance companies. Commercial banks are the largest and most prominent financial

intermediaries in the economy and offer the widest range of financial services to

businesses.

2.15 Financial Markets: What is the main difference between money markets and capital

markets?

LO 3

Solution: Money markets are markets in which short-term debt instruments with

maturities of less than one year are bought and sold. Capital markets are markets in which

equity securities and debt instruments with maturities of more than one year are sold.

2.16 Money Markets: What is the primary role of money markets? Explain how money

markets work.

LO 3

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Solution: Money markets provide an option for large corporations to adjust their liquidity

positions. Since only seldom are cash receipts and cash expenditures perfectly

synchronized, money markets allow companies to temporarily invest idle cash in

Treasury bills or negotiable CDs. If a company is short on cash, it can borrow the money

from money markets by selling commercial paper at lower interest rates than through

commercial banks.

2.17 Money Markets: What are the main types of securities in the money markets?

LO 3

Solution: Treasury bills, bank negotiable CDs, and Commercial paper.

2.18 Capital Markets: How do capital market instruments differ from money market

instruments?

LO 3

Solution: Capital market instruments are less liquid or marketable, they have longer

maturities, usually between 1 and 30 years, and they carry more financial risk.

2.19 Market Efficiency: Describe the informational differences that separate the three forms

of market efficiency.

LO 4

Solution: The strong form of market efficiency states that all information is reflected in

the security prices. In other words, there is no private or inside information, that if

released would potentially change the price. The semistrong-form holds that all public

information available to investors is reflected in the security’s price. Therefore, insiders

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with access to private information could potentially profit from trading on this knowledge

before it becomes public. Finally, the weak form of market efficiency holds that there is

both public and private information that is not reflected in the security’s price and having

access to it can lead to abnormal profits.

2.20 Market Efficiency: Zippy Computers announced strong fourth quarter results. Sales and

earnings were both above analysts’ expectations. You notice in the newspaper that

Zippy’s stock price went up sharply on the day of the announcement. If no other

information about Zippy became public on the day of the announcement and the overall

market was down, is this evidence of market efficiency?

LO 4

Solution: Yes, if no other information became public and the market was down, the

increase in Zippy’s price most likely reflects the effects of investors trading on the good

news. Investors, believing that Zippy is now more valuable than they had thought are

willing to pay a higher price for the shares.

2.21 Market Efficiency: In problem 2.20, if the market is efficient, would it have been

possible for Zippy’s stock price to go down in the day that the firm announced the strong

fourth quarter?

LO 4

Solution: Yes. The last sentence in the statement of problem 2.20 suggests why this

might happen. If, on the same day of the announcement, some very bad news about the

future prospects for Zippy became public or if the market went down substantially,

Zippy’s stock price might also have gone down despite the positive sales and earnings

announcement.

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2.22 Market Efficiency: If the market is strong-form efficient, then trading on tips you hear

from Jim Cramer (the host of Mad Money on CNBC) will generate no excess returns

(i.e., returns in excess of fair compensation for the risk you are bearing).

LO 4

Solution: True. If the market is strong-form efficient then all new information gets

reflected in stock prices very quickly. In such a market there is nothing you will hear

from Jim Cramer on his TV show that will enable you to consistently earn excess returns.

The information in his tips will already be reflected in stock prices by the time you can

trade on them.

2.23 Financial Markets: What are the major differences between public and private markets?

LO 3

Solution: Public markets are organized financial markets where the public buys and sells

securities through their stock brokers. The SEC regulates public securities markets in the

United States. In contrast, private markets involve direct transactions between two

parties. These transactions lack SEC regulation.

2.24 Financial Instruments: What are the two risk-hedging instruments discussed in the

chapter?

Solution: The two risk-hedging instruments discussed are futures and options markets.

LO 3

2.25 Interest Rates: What is the real rate of interest, and how is it determined?

LO 6

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Solution: The real rate of interest measures the return earned on savings, and it

represents the cost of borrowing to finance capital goods. The real rate of interest is

determined by the interaction between firms that invest in capital projects and the rate of

return businesses can expect to earn on investments in capital goods, and individuals’

time preference for consumption. Graphically, it is that point when the desired saving

level equals the desired level of investment in the economy.

2.26 Interest Rates: How does the nominal rate of interest vary over time?

LO 6

Solution: The nominal rate is the rate that we observe in the marketplace. it is

determined by both the real rate as well expected inflation. Therefore, the nominal rate

will fluctuate according the changes in the real rate as well as changes in expected

inflation.

2.27 Interest Rates: What is the Fisher equation, and how is it used?

LO 6

Solution: The Fisher equation is the expected, not the reported or actual, annualized

change in commodity prices (∆Pe). It is used to protect the buying power from changes in

inflation, and it is incorporated into a loan contract by adding it to the real interest rate

that would exist in the absence of inflation.

2.28 Interest Rates: Imagine you borrow $500 from your roommate, agreeing to pay her back

the $500 plus 7 percent interest in one year. Assume inflation over the life of the contract

is expected to be 4.25 percent. What is the total amount you will have to pay her back in

a year? What percentage of the interest payment is the result of the real rate of interest?

LO 6

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Solution: You will pay her back $535 ($500 × 1.07) in one year. Given an inflation of

4.25 percent, the real rate of interest is 2.75 percent. This means that $13.75 will be a

result of the real interest rate ($500 × 1.0275).

2.29 Interest Rates: Your parents have given you $1,000 a year before your graduation so

that you can take a trip when you graduate. You wisely decide to invest the money in a

bank CD that pays 6.75 percent interest. You know that the trip costs $1,025 right now

and that the inflation for the year is predicted to be 4 percent. Will you have enough

money in a year to purchase the trip?

LO 6

Solution: Yes. The CD will be worth $1,067.50 at the end of the year ($1,000 x 6.75% +

$1,000), and the price of the trip will be $1,066 ($1,025 x 4% + $1,025). The CD will be

able to cover the trip.

2.30 Interest Rates: When are the nominal and real interest rates equal?

LO 6

Solution: The only time the nominal and real interest rates are equal is when the

expected rate of inflation over the contract period is zero.

Sample Test Problems

2.1 How are brokers different from dealers?

Solution:

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Brokers execute transactions for their clients, but they bear no risk of ownership of the

securities in the transaction; in contrast, dealers “make markets” for securities and do

bear risk.

2.2 What is an investment fund?

Solution:

An investment fund sells shares to investors and uses the funds to purchase securities.

2.3 Identify the type of transactions (direct or indirect) the following are:

a. You buy 200 shares of Fidelity Growth Mutual Fund.

b. Roger opens a bank CD for $5,000.

c. Bank of America makes a $25,000 loan to Leila Coffee Shop.

d. Nora buys $3,000 of Xerox bonds from a new issue.

Solution:

a. indirect, since Fidelity is an investment fund

b. indirect, since the bank will then loan the funds to a deficit spending unit

c. direct, since Bank of America is a money center bank, which is making a direct loan

d. direct, since Nora is buying the new issue through an investment bank

2.4 If the nominal rate of interest is 7.5 percent and the real rate is 4 percent, what is the expected

inflation premium?

Solution:

If we follow the Fisher equation,

i = r + ∆Pe and note that i = 0.075 while r =0.04, then it is easy to see that ∆Pe = 0.035 or

3.5%.

2.5 What is the relationship between business cycles and the general level of interest rates?

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Solution:

As Exhibit 2.5 shows, we can see that interest rates tend to follow the business cycle.